The problems of financial illiteracy

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I was keen to go to the panel on financial literacy, which was moderated by John Bryant, the founder of Operation HOPE and a member of the U.S. President’s Advisory Council on Financial Literacy. He’s clearly committed to this cause, and is doing a very good job of picking the low-hanging fruit: in some areas, for instance, only 25% of people eligible for the Earned Income Tax Credit actually claim it. Since it can be claimed going back three years, and since it can amount to $4,000 per year, families earning less than $40,000 a year can end up with a $12,000 windfall just as a result of some simple outreach and basic education. In many cases that’s “more money in many cases than they’ll ever see in their life,” said Bryant; “it’s transformational”.

I was disappointed, however, in the way that Bryant kowtowed to the credit-card representatives on the panel: I think they’re clearly a big part of the problem, but Bryant said that he loves credit cards, on the grounds that they represent the only credit line that most poor families have.

My feeling, by contrast, is that credit cards are a really bad way of structuring an unsecured personal loan from a bank to an individual. Banks have made a concerted effort to make personal loans very difficult and expensive to obtain, complete with prepayment penalties and the like, precisely because they’d much rather their borrowers run a balance on their credit cards. And so I had no sympathy at all for David Simon, of Citicards, when he started moaning about how banks were taking enormous credit losses and how “credit card companies are the people that we love to hate”. Well, yes: because they’re basically evil, with what Elizabeth Warren calls their “tricks and traps”. But no one pushed them on this panel.

While the Obama administration continues to push on credit card regulations, and that’s a very good thing, I’d be much more interested in a parallel push to bring back the old-fashioned personal loan: something which is designed to be paid down over time, and which carries a transparent interest rate. Disappointingly, no one on the panel even mentioned the phrase “credit unions”, despite the fact that credit unions in general, and community development credit unions in particular, are a great way to educate the public on financial matters and to extend good loans rather than bad ones.

Instead, the conversation remained firmly at about 40,000 feet most of the time, with lots of talk about things like the parallels between physical and financial health: in both cases Americans have consistently failed to take responsibility for their own well-being, with disastrous consequences.

The most sanity was injected by Sean Cleary, who did push back a bit against the card issuers, saying that an economy with 8.5 credit cards per person is “a completely dysfunctional institutional context”. He also noted a powerful truism:

If you do not have the quantum of life skills needed to succeed in today’s market-based economy, then you will fail.

There was, unfortunately, very little discussion of how exactly to give Americans those skills. There was a reference to a recent paper by Annamaria Lusardi and Peter Tufano, which sought to measure financial literacy, and found that only 7% of people could answer this question correctly:

You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?

(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.

Lusardi and Tufano are clear that (ii) is the right answer: a 20% interest rate is much better than the 35% APR on the installment plan, and people who don’t answer (ii) are ignorant, they say, of the time value of money.
But of course there are good reasons to want to pay an affordable repayment every month rather than simply putting off for a year — and exacerbating by $200 — the question of how on earth you’re going to pay for this appliance. If we want financial-literacy classes to be really helpful, I think they should concentrate not on teaching people the “right” answer to a time-value-of-money question, but rather just make people understand that there are fundamental sustainability problems whenever you’re spending more than you’re earning.

Banks are really bad at communicating to their customers that personal loans, including credit cards, should only be used when you are pretty sure that you have a way of paying that loan back in the future. That is real, useful financial literacy, and it requires very little in the way of boring mathematical concepts.

I’m happy however that no one said anything about financial-literacy education involving learning about investments. That’s a fraught area indeed, and it’s far from clear that teaching people about the stock market is ever a good idea. If you want to get rich, there’s really only one way to do it: spend less than you earn. Borrowing money, for most people, is a very bad way of getting wealthier, and investing money, for most people, doesn’t work particularly well either. Don’t count primarily on investment returns: instead, just try to put money away, steadily, month in and month out, until you retire with a decent nest egg.

But pay off those credit cards first.

Update: I’d like to respond to James Shearer, in the comments, who writes this:

Either way you pay $1200. So the second option is clearly better as long as interest rates are greater than 0.

Which is the “right” answer, assuming that a rational person would simply take the $100 a month they’d otherwise spend on the installment plan, and put it in an interest-bearing account: at the end of the year, they can repay the full $1200 in a lump sum, and keep the interest.

But in the real world, people don’t do that. An installment plan is a commitment device, much like a mortgage, and there’s serious value to such a device. Under option (a) you end the year owing nothing; under option (b) you end the year owing $1,200 — and there’s a very good chance that you’ll have no more money then than you do now.